March 17, 2012
India Budget 2012: A Jolt to Foreign Investors
Far reaching impact on M&As, Fund Industry and Protection of Foreign Investments
The 2012 Budget presented by the Finance Minister has shaken the international investor community. The Budget proposes a number of regressive, retrograde and extraterritorial provisions that would significantly increase tax costs and alter the dynamics of cross-border transactions and M&As. The proposal to retroactively override the Supreme Court’s decision in the Vodafone case with effect from 1962 raises a question as to whether foreign investments are protected in India at all and whether it will give rise to claims under bilateral investment protection treaties.
The further surprise is the utter disrespect to the Parliamentary Standing Committee on Finance which submitted its report on March 9, 2012 (last Friday) severely criticizing the proposals in the Direct Taxes Code Bill 2010 (“DTC”). Although the Finance Minister expressly stated in his Budget speech that the Government will be reviewing the Standing Committee’s report, these proposals seem to have found a way into the 2012 Budget without any consideration for the Committee’s recommendations.
In the face of global financial slowdown, decline in India’s GDP growth from 8.4% to 6.9% and high inflation, a ‘reformist’ budget is normally prescribed to kick start the economy. Unfortunately, the 2012 Budget does not propose any notable fiscal reforms or incentives of far reaching impact. No reduction has been proposed with respect to corporate tax rate of 32% plus 16% on the distributed profits, taking effective tax rates to the level of around 42%. India continues to be one of the highly taxed countries.
Will foreign investors think twice?
The proposals to tax offshore share transfers and the introduction of general anti-avoidance rules (“GAAR”) will have the most critical impact on foreign investors.
Overriding the Supreme Court’s celebrated decision in the USD 11.1 billion Vodafone case, the Government proposes to retroactively tax offshore share transfers of foreign companies, the value of which is substantially derived from assets located in India. The proposal results in the piercing of typical offshore holding structures, and will make it nearly impossible for investors to plan cross-border M&As and group restructurings. This will also have a significant impact on fund investors.
By being subject to Indian tax on account of artificial deeming fictions, investors are also exposed to the risk of double taxation without any credit for taxes paid in India. For example, if a US shareholder transfers shares of a US company holding shares of an Indian company, the US investor will be subject to tax in India. At the same time, being a US resident, it would also be taxed in the US.
The Government’s knee jerk reaction in retrospectively taxing offshore share transfers in the aftermath of the Revenue’s defeat in the Vodafone case will considerably erode India’s standing in the eyes of investors and treaty partners. The extraterritorial nature of these provisions also suffers from constitutional limitations.
The GAAR provisions have been severely criticized on account of the wide discretionary powers conferred upon the Revenue in taxing transactions on grounds of tax avoidance. The ambiguously worded GAAR provisions capture most conventional structures for M&As and investments into India. GAAR will also override the provisions of tax treaties signed by India. Even genuine and legitimate tax planning may be hit by GAAR. If implemented, GAAR will open up a Pandora’s box of uncertainty and litigation, and investors may be forced to think twice before considering opportunities in India. For such reasons, GAAR was one of the most controversial provisions in the DTC that was presented to Parliament back in 2010. After considering grievances voiced by taxpayers and investors worldwide, the Parliamentary Standing Committee on Finance, in its report presented on March 9, 2012, recommended sweeping changes to the form and content of the DTC. [Please click here for a summary of the Standing Committee’s report and here for a summary of our recommendations presented to the Committee].
The Standing Committee acknowledged the potential for misuse of GAAR in the hands of the Revenue, and suggested that the provisions be completely recast in the interest of ensuring fairness, accountability and certainty. In utter disregard to the well-considered analysis and comments of the Committee, the Government has moved with immense haste in proposing a GAAR without incorporating any of the internationally recognized safeguards, checks and balances.
New compliance challenges
Claiming treaty benefits:
The Budget proposals give rise to onerous compliance challenges for foreign investors. For claiming treaty benefits, non-resident taxpayers will be required to obtain a tax residency certificate containing specific particulars as may be prescribed by the Revenue. It is hoped that the Revenue does not transgress their authority by prescribing criteria for residence in a foreign jurisdiction that is not contemplated under the tax treaty.
Reopening past cases:
The Budget also increases the time period for taxing prior transactions from 6 years to 16 years, making it extremely difficult for taxpayers to maintain necessary documentation and manage litigation risks. While such proposals increase compliance costs for taxpayers, the Revenue is endowed with additional tools of harassment and abuse of power.
Disclosure of foreign assets: Impact on fund managers
With inspiration from the US, the Budget proposes to make it mandatory for Indian residents to report their overseas assets including interests in foreign entities, financial interests or signing authority in any offshore account. This is regardless of whether the resident has earned any income in a financial year. This will have an impact on fund managers where carried interest and co-investment structures set up abroad will have to be necessarily disclosed to the tax authorities irrespective of any returns being derived.
Domestic transfer pricing:
In addition, domestic companies will have to grapple with transfer pricing compliances in relation to intra-group transactions over INR 50 million in value. Currently, transfer pricing provisions only apply to international transactions.
Retrograde Retroactive law making
The slew of retroactive amendments in the Budget is unreasonable, arbitrary and violative of fundamental rights guaranteed under the Indian Constitution. In most cases in the budget, the period of retroactivity extends to a period of more than half a century. Such retroactive imposition of taxes militates against the legitimate expectations of taxpayers and investors.
In the words of a 5 Judge Constitutional Bench of the Supreme Court, “retrospective taxation imposes an unjust and unwarranted accumulated burden on the assessee for no fault on his part… Imposition of any tax with retrospective effect for years for which no such tax was there, cannot also be considered to be just and reasonable.” (Lohia Machines 152 ITR 308)
Shifting to a trust based tax regime
“I must be cruel only to be kind”, confessed the Finance Minister while introducing his direct tax proposals. Noble as the quote from Hamlet may seem, it looks like cruelty can at times know no bounds. The Budget has turned out to be big blow for foreign investors and has seriously affected India’s credibility. Several proposals have to be completely overhauled in light of specific taxpayer concerns and the detailed recommendations of the Standing Committee.
It is important for India to move towards a trust based tax regime that guarantees internationally recognized taxpayer rights including: (i) enforcement of tax laws in a fair, equitable and non-arbitrary manner, (ii) non-retroactive imposition of taxes, (iii) certainty and stability; (iv) guarantee against double taxation and good faith interpretation and enforcement of tax treaty provisions; and (v) efficient redressal of tax disputes within a reasonable time frame. Alas! The Budget has done exactly otherwise.
We have provided below a more comprehensive analysis of the Budget proposals. Hope you enjoy reading it.
The Finance Bill, 2012 (“Budget”) does not propose any change to the basic corporate tax rate. The corporate income tax rate remains unchanged at 30% for an Indian company and 40% for a foreign company. The surcharge applicable on income tax for companies with total income exceeding INR 10 million also remains the same at 5% in the case of domestic companies and 2% for foreign companies. There has been no change made to the education cess which is presently levied at the rate of 3%. Thus the effective tax rates (taking into account dividend distribution taxes also) continues to be in the range of around 42%. Further, no change has been made to the 30% tax rate applicable to co-operative societies, firms and local authorities.
However, the Alternate Minimum Tax (“AMT”) of 18.5%, which was applicable to Limited Liability Partnerships (“LLP”), is proposed to be levied on all persons, other than companies (which are subject to minimum alternate tax). This would include partnerships, sole proprietorships, association of persons etc.
Effective from July 1, 2012, the Budget proposes to reduce the rate of STT to 0.1% (effective July 1, 2012) from the present 0.125% on delivery-based transactions, i.e. purchase and sale of equity shares of a company / units of an equity oriented fund entered into on a recognized stock exchange in India. This should reduce costs of capital market transactions.
The Budget has introduced some changes to the withholding tax rates and also provided some incentives in respect of the withholding tax rates for interest. At the same time, it has expanded the definition of ‘royalty’ besides extending withholding tax obligations on sale of immovable property. Withholding tax obligations have also been extended to any payments made to non-residents, even if made by non-residents not having a presence in India.
Interest : Succor for infrastructure industry
The withholding tax rate applicable while making interest payments to non-residents on External Commercial Borrowings (“ECB”) (i.e. borrowings in foreign currency) has been reduced from 20% to 5% for specific sectors like power, airline, roads, bridges, affordable houses, fertilizer and dams1. This proposal seeks to provide long- term, low cost, funds to the stressed infrastructure sectors.
Immovable Property : Withholding introduced
Further, with effect from October 1, 2012 withholding of tax on transfer of immovable property (other than agricultural land) is proposed to be imposed wherein every transferee, at the time of making payments or crediting the consideration for transfer of immovable property, shall deduct tax at the rate of 1% of such sum, subject to de-minimus principles.
Withholding taxes on royalty : Expanding the boundaries
Payments of royalty made to a non-resident (as well as to a resident) are subject to withholding tax at the rate of 10%. The definition of the term ‘royalty’ has often been a subject matter of dispute and this year’s Budget theme seems to be the nullification of court rulings by way of retrospective amendments. The Budget has introduced ‘clarificatory’ explanations to be added to Section 9(1)(vi) of the Act to target payments towards shrink-wrap and embedded software, online databases and data clouds, which have been disputed before Indian tax courts in the past (except data clouds) and include them within the ambit of ‘royalty’.
The proposed explanation to the definition of ‘royalty’ seeks to include (and clarifies that it has always included) transfer of any right to use a computer software including the granting of a license, irrespective of the medium through which such right is transferred targeting the taxation of shrink-wrap or embedded software (examined in Sonata Software or Lucent Technologies). Taxation of online databases have been examined in cases such as Dun & Bradstreet Espana all of which held in favor of the taxpayer and emphasized the difference between sale of a copyrighted object (such as a book, or a CD containing software) versus license of a copyrighted article. The revenue authorities however have been persistent in their efforts, the result of which are rulings such as Microsoft, which held that payments towards shrink-wrap software are in the nature of royalties, being consideration for a ‘copyright’. The proposed amendment attempts to confirm the revenue position by bringing embedded products, online subscription products, shrink-wrap software etc within the ambit of royalty, notwithstanding that they are merely a sale of a good in electronic form.
Further, additional explanations have been introduced to state that royalty includes consideration for a right irrespective of whether the taxpayer holds possession of such right, uses such right directly or whether or not such right is located in India. This could potentially cover payments towards online databases which (as discussed above) have been disputed in the past. As a result potential targets include cloud computing services providers who could be covered if they have an Indian customer base. Additionally, payments towards satellite transmission services have been brought within the definition of royalty, again reversing previous favorable judgments holding that the same does not qualify as royalty. The impact of this is that non-resident broadcasters could be required to pay tax on royalty in India on account of having a footprint in India, irrespective of whether any other source conditions are satisfied.
The Budget disregards principles of sovereignty in the context of data clouds, satellite transmissions or online databases since it imposes no thresholds on when a data cloud / satellite should be considered to have income taxable in India. While there is no restriction on expansion of Indian tax base to growing sectors, it is disappointing to see a lack of foresight in relation to a changing economy which is likely to get more reliant on technology and intangible products by the day. From a macro-level perspective it may be important to examine what revenue authorities may achieve by making a habit out of enacting legislative changes that dates back 40-50 years, not merely in the context of royalty but generally in various provisions in the Act.
Withholding taxes on payments made by a non-resident to another non-resident
The question of whether a non-resident who does not have a presence in India could be subject to withholding tax obligations was answered in the negative by the Indian Supreme Court in the recent Vodafone Judgment. This ratio was thought to be a rational move considering the fact that withholding taxes are administratively easier to collect and a burdensome obligation should not be imposed on a non-resident not having any tax presence in India. However, the Budget has sought to circumvent the ruling by introduction of an explanation to clarify that withholding tax obligations apply to all non-residents, irrespective of whether they have any presence whatsoever in India.
This is a regressive move by the Indian Government to overrule the reasoned decision set out by the Supreme Court that a requirement of tax presence was necessary for imposing a withholding tax obligation. It will lead to significant hardship for foreign investors seeking to either invest in India or seeking to transact with non-residents in relation to activities pertaining to India and goes against the principle of territorial nexus for imposition of tax burden on any tax payer. This also implies that issues such as obtaining adequate protection through tax indemnities will again continue to be critical for foreign investors in situations involving acquisition of shares from other non-residents, amongst others. Further, considering provisions relating to General Anti-avoidance Rules (“GAAR”) and taxation of indirect transfer of assets are also sought to be introduced into the tax base, the buyer may be adversely prejudiced since there is no certainty relating to the taxation of the transaction and there may be potential withholding tax claims raised against the buyer even in situations where GAAR has been applied. The absence of any limitation period for raising such claims for a payment to a non-resident leads to an absolute lack of clarity in relation to the withholding tax obligations for a non-resident who is making a payment to another non-resident.
The Budget further proposes to empower the Central Board of Direct Taxes (“CBDT”) to ascertain and notify a class of persons or cases where the person responsible for paying a non-resident would be required to make an application to the revenue officer to determine the appropriate portion of sum chargeable and to deduct taxes in respect of the same. It is unclear which cases would be targeted under this provision, but there will be an increase in the time line for effectuating a transaction which can lead to increasing complexity and administrative burden for completing a transaction.
Offshore / Indirect Share Transfers: Dialing out Vodafone
In a glaring example of a Supreme Court judgment being nullified by retrospective amendment to the tax statute with complete impunity, the Budget proposes to levy tax on indirect transfers of Indian entities by non-residents. This is a calculated move to undo the pronouncements of the Apex court in the recent Vodafone2 case, as confirmed by the Memorandum to the Budget which states that the rationale for the move is to clarify the law in light of ‘certain judicial pronouncements’. The key changes that have been brought about to tax such indirect transfers are:
a. Definition of a ‘capital asset’: The current definition of capital asset includes property of any kind held by a taxpayer (with certain exceptions). In the Vodafone case, this became a stumbling block for the revenue authorities as the definition did not cover property indirectly held. The Budget has responded to the revenue’s problem by retaining the inclusive definition and further expanding it to include any rights whatsoever in (or in relation to) an Indian company, including the rights to manage and control it. This also raises issues on what constitutes a right to manage and control the Indian company and may extend to concepts such as voting rights agreement, right to appoint directors etc.
b. Definition of a ‘transfer’: The current definition of transfer includes any sale, exchange, extinguishment or relinquishment of rights. It has been clarified that ‘transfer’ shall include the creation or disposing of any interest in any asset in any manner whatsoever (i.e. directly, indirectly, absolutely, conditionally, voluntarily, involuntarily by way of an agreement entered into in India or outside India or otherwise). Considering that India does not at present recognize the concept of beneficial ownership (except in a limited context such as agency), it would be important to consider how this disposition of an ‘interest’ would interplay with the disposition of a separate ‘legal’ right. The Budget in its blind reactivity unfortunately provides no answers. Additionally, the expanded ambit takes into account agreements such as an option agreements, contingent contracts etc. which only add to the confusion on when a capital asset has been transferred for the purposes of the Act.
c. Scope of Income deemed to accrue / arise in India: Section 9(1)(i) of the Act, creates a legal fiction to tax, deeming all income accruing or arising through the transfer of a capital asset situate in India. This term proved to be an issue in Vodafone since the actual asset transferred was not in India. In reaction, this Budget adds an explanation to clarify that the expression ‘through’ shall mean and includes ‘by means of’, ‘in consequence of’ or ‘by reason of’. A further explanation is proposed whereby it is clarified that a (capital) asset being any share / interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India if the share or interest derives (either directly or indirectly) its value substantially from the assets located in India. Unfortunately the Budget provides no clarity on whether there will be Indian tax implications both on the indirect disposition as well as the direct disposition of the Indian asset, which is likely to leave taxpayers confused and left to the caprices of revenue authorities. Further, the Act does not deal with a situation of double taxation, whether credits would be granted in India for taxes paid overseas and also the interplay between a tax treaty and the Act in case of an indirect transfer. If anything, this is a recipe for chaos leading to an increased scope of litigation besides creating conflicts with revenue authorities in other jurisdictions.
d. Withholding Tax Provisions: As detailed earlier, the Budget seeks to include an explanation to extend the application of withholding tax on payments to non-residents, to all persons, resident or non-resident, whether or not the non-resident has a residence or place of business or business connection in India; or any other presence in any manner whatsoever in India. Questions have been raised in relation to the usefulness of applying withholding provisions on non-resident to non-resident payments, but these have not been considered in the Budget.
e. Procedural provisions: A revenue officer could be empowered to reopen cases for up to 16 years instead of the currently applicable 6 years. Further, the provision contains a carve out which does not make the limitation period applicable to income which has escaped assessment including income in relation to any asset (including financial interest) in any entity located outside India. This could potentially result in such incomes not having a limitation period applicable at all.
f. In a diminutive yet critical enactment, the Budget seeks to introduce a provision which seeks to validate any notice (or proposed to be) sent, taxes levied / demanded / imposed / recovered, etc. under the Act and deems such notice to have been validly made in respect of income accruing or arising through or from the transfer of a capital asset situate in India in consequence of (i) the transfer of share(s) of a company registered or incorporated outside India or (ii) an agreement, or otherwise, outside India. It is proposed that such notice cannot be challenged on the ground that it is a tax on capital gains arising out of transactions which have taken place outside India. Further, there shall be no liability or obligation to make any refund whatsoever in relation to the above. As the last straw, this provision sought to be introduced overrides any Court / tribunal / other authority’s judgment, decree or order. The constitutionality of such a wide ranging provision is inherently suspect and likely to be challenged sooner than later. What is more disappointing though, is the Legislature’s attempt to try and bring the taxpayer within its tax net by hook or crook, basic principles of natural justice and rule of law notwithstanding.
While the amendments project themselves as ‘clarificatory’ changes, they significantly expand the Indian tax jurisdiction by creating a new charge applicable to offshore transfers. Taxing statutes are interpreted strictly and there is a presumption as to the territorial application of a statute unless otherwise specified. Therefore, by introducing a ‘clarification’ that rebuts this presumption, the impact of the amendment is to create a new levy. Another important aspect to be noted is that the changes proposed by the Budget must pass the litmus test of reasonableness, non-arbitrariness and constitutionality. A well accepted principle is that while the legislature can introduce retrospective provisions, Courts are empowered to strike down such provisions when contested on the ground of contravening fundamental rights3.
Given that the above amendments will take effect retrospectively from April 1, 1962, we are left questioning the necessity of retroactive application from fifty years prior to the date of introduction, and the grounds for justifying it4. While there is per se nothing to prevent retrospective applicability of a statute, the Indian Supreme Court has on the issue of retrospective application of a taxing statue laid down clear principles that:
“the power to amend the law with retrospective effect is subject to several judicially recognised limitations, one of which being that the retrospectivity must be reasonable and not excessive or harsh, otherwise it runs the risk of being struck down as unconstitutional and another being that where the legislation is introduced to overcome a judicial decision, the power cannot be used to subvert the decision without removing the statutory basis thereof.”5 [EMPHASIS SUPPLIED]
The key test being that, explanatory or clarificatory retrospectivity is acceptable whereas amendments that retrospectively introduce a substantive obligation are clearly unconstitutional. Further, it must be as per the (holy) basic structure doctrine of the Indian Constitution, the legislature is empowered to legislate; but such law is subject to judicial scrutiny. The Finance Ministry, with the proposed amendments on taxation of indirect transfers seems to have lost sight of the constitutional obligations that are set out on the legislative authorities in passing amendments to law with retrospective effect.
Tax Treaty Override: Or Tax Treaty Overdrive?
The current position in law is that the Act is applicable to a tax payer to the extent it is more beneficial than any applicable tax treaty. Further, the Indian Supreme Court in the case of Azadi Bachao Andolan had upheld the circular issued by the CBDT that a Tax Residency Certificate (“TRC”) issued by the Mauritian tax authorities would constitute sufficient evidence for providing tax treaty benefit. The Budget proposals mark a departure from both, principles that have been long standing and established principles under the Act.
The first proposed amendment stipulates that the GAAR may continue to apply to taxpayers even if it may be less beneficial to the taxpayer. This obviously introduces a significant uncertainty for any foreign investor on the quantum of liability that may be applicable and since the fact of reliance on the tax treaty provisions and its established rules of interpretation may no longer suffice.
The second proposed amendment stipulates a procedural requirement on non-residents claiming the benefits of a tax treaty. It is provided that treaty benefits would not be available to non-residents unless they produce a TRC obtained from the Government of the country or specified territory. What makes it a more onerous amendment is that such a TRC is not considered to be conclusive evidence of a taxpayer’s residence in the country or territory issuing it. In the first place, not every country may issue a TRC and this may result in the denial of treaty benefits due to procedural issues. Additionally, this would in effect mean an implicit overriding of the principles that were set out in the Azadi Bachao Andolan case that a TRC can constitute sufficient evidence for providing treaty benefit. The impact of this along with the GAAR provisions may result in protracted litigation with the revenue authorities on any matter relating to treaty benefit.
GAAR: A one shot penicillin for all ailments
The Budget proposes to introduce comprehensive GAAR, effective from April 1, 2012. It seems that the proposed GAAR provisions are wider than what was proposed initially in the Direct Taxes Code Bill. GAAR seeks to provide wide powers to the revenue authorities in taxing ‘impermissible avoidance arrangements’ including the power to disregard entities in a structure, reallocate income and expenditure between parties to the arrangement, alter the tax residence of such entities and the legal situs of assets involved, treat debt as equity and vice versa, and the like. By doing so, the revenue authorities may deny tax benefits even if conferred under a tax treaty.
An ‘impermissible avoidance arrangement’ is defined as an arrangement where the main purpose (or one of the main purpose) is to obtain a tax benefit and which contains any of the following elements:
a. Non-arm’s length transactions: Arrangements that create rights or obligations not normally created between independent parties transacting on an arm’s length basis.
b. Misuse or abuse of the Act: The Budget does not provide any clarity on what will constitute a misuse or abuse. It is possible that a misuse or abuse of the Act may refer to arrangements that seek to take advantage of a loophole in the law, thereby obtaining a tax benefit that was never contemplated by the legislature.
c. Non - bona fide purpose: Arrangements that are carried out by means or in a manner which is not ordinarily employed for a bona fide purpose. While there is no clarity on the scope of this expression, it understood that it may cover arrangements that are abnormal or which are not genuine.
d. Lack of commercial substance: Certain arrangements are deemed to lack commercial substance. This would include round trip financing involving transfer of funds between parties without any substantial commercial purpose. Also covered are self-cancelling transactions, arrangements which conceal, and the use of an accommodating party, the only purpose of which is to obtain a tax benefit. Arrangements are also deemed to lack commercial substance if the location of assets, place of transaction or the residence of parties does not have any substantial commercial purpose.
For invoking GAAR, the tax officer is required to make a reference to the Commissioner of Income Tax (“CIT”) who will decide on the applicability of GAAR. If the taxpayer contests the CIT’s decision, the matter will be referred to the Approval Panel, a reviewing body comprising a minimum of 3 tax officials of the rank of CIT or above. The Approval Panel is required to make its decision within a period of 6 months and the same is binding on the taxpayer and the tax officer.
The proposed GAAR (if implemented) will create tremendous uncertainty in India’s investment and business environment. GAAR imposes onerous compliance burden on taxpayers and investors who will now find it increasingly difficult to plan their economic affairs. The enhanced 16 year window for assessing prior international transactions will add to the woes of investors. The wide discretionary powers provided to the revenue authorities give much room for misuse and will increase litigation in the country. The use of ambiguous expressions such as misuse, abuse, bona fide purpose, substantial purpose and commercial substance will result in subjective interpretation and implementation of the law.
The GAAR provisions are likely to capture most of the conventional M&A structures including structures for investments into India, especially since tax mitigation is always a key consideration. Several genuine legitimate tax planning arrangements and investments through popular jurisdictions such as Mauritius, Singapore and Cyprus may be hit by GAAR. The application of GAAR can give rise to double taxation in cases where taxpayers are denied treaty benefits on the basis of the subjective interpretation of the facts under the GAAR provisions. Investors may also be denied the benefit of advance rulings on GAAR matters due to limitations in the current statutory provisions.
While GAAR provisions are proposed to be effective from April 1, 2012 there is no express guarantee that prior structures are excluded. The GAAR provisions clarify that the holding period of a structure or arrangement and the fact that it provides a legitimate exit route for investors is not relevant for the purpose of determining commercial substance. This clearly overrides the reasoning used by the Indian Supreme Court when it accepted the legitimacy of the Hutch structure which was in place for several years prior to the acquisition by Vodafone.
It is hoped that the Indian Government realizes the dangers of introducing a widely drafted GAAR provision and its negative impact on investments and capital formation in India. The GAAR provisions have to be completely recast in a manner that ensures fairness, predictability and certainty for taxpayers and investors world-wide.
Share subscription premium made taxable
The Budget proposes to tax any share premium that is paid for subscription to shares of a company that is in excess of the Fair Market Value (“FMV”). This applies in respect of issuance of shares to an Indian tax resident by a private limited company or unlisted public limited company6 (i.e. a company in which the public is not substantially interested). Such excess premium would be chargeable to tax as “income from other sources”.
Further, the “FMV” is deemed to be the higher of:
a. The amount, as may be substantiated by the company before the tax officer based on the value of its assets including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature; or
b. As maybe determined as the method prescribed under the relevant rules for calculation of FMV.
An exception has been carved out in case where consideration is received for issuance of shares to a venture capital company or a venture capital fund by a venture capital undertaking.
While the ostensible intent behind the proposal is to curb generation and use of unaccounted money, the proposal if passed by the legislature in its current avatar may end up taxing premium even in cases where there is a genuine commercial reason for subscribing shares at a premium e.g. from an corporate law perspective share premium can be utilized for payment of premium on buy-back of securities or even conversion of convertibles at a premium to maintain inter se shareholding percentage. Further, having to justify FMV in various other situations like anti-dilution situations where existing shareholders are issued shares at a discount to new investors, investments involving premium paid on account of strategic value of a business, etc. would likely result in more tax litigations. This proposal in the current form can pose significant challenges for structuring of genuine investments into companies.
Taxing earn outs and contingent payments
The Budget has introduced a new provision which provides that if the consideration received upon transfer of a capital asset is unascertainable, then the consideration shall be deemed to be the fair market value of the asset on the date of transfer. This provision appears to be a reaction to rulings such as the AAR ruling in In Re Dana Corporation, where the unascertainability of consideration in case of restructuring of an insolvent company was considered grounds for non-levy of tax. The ruling followed the principle laid down by the Supreme Court in the case of BC Srinivasa Shetty which held that the charging and computation provision of the Act constituted an integrated code, and once the computation mechanism under the Act fails no capital gains tax liability fails. The proposed section seeks to deem a consideration where no value is ascertainable which may lead to unfair or absurd consequences in certain cases. For example, issues may arise relating to taxation of M&A transactions where there are contingent payments. The provision seems to indicate that in such cases, the consideration may then be determined based on a fair market value at the time of the M&A rather than taxation at the time of receipt of potential future consideration. This in turn could lead to excessive or inadequate capital gains tax being paid at the time of transfer of the capital asset.
Rationalization of Merger / Demerger exemption provisions: A silver lining
On the positive side, Indian merger and demerger provisions have been rationalised. Under the current regime, in order for a merger to qualify as a tax free merger, it is required that shares have to be issued by the resulting entity to the shareholders of the merging entity. An amendment to the current section 47(vii) states that if the shareholder of the merging entity is also the resulting entity, then the requirement in relation to the issuance of shares will no longer exist. This is a welcome move since the literal application of the previous exemption provision created ambiguity as to whether mergers into a parent would be tax exempt, since a company cannot technically issue shares to itself.
Holding company structures: Cascading tax impact removed
A welcome move is the proposed amendment to section 115-0 which takes us closer to corporate consolidation in India. Under Section 115-O of the Act, an Indian company is required to pay dividend distribution tax (“DDT”) at the rate of 15% on dividends that are declared, distributed or paid by a domestic company. The Indian tax regime has never been favorable to multilayered corporate structures on account of the fact that it required dividend distribution at each level of corporate distribution, even within the same group structure. In 2009, a benefit was introduced whereby dividends receive by a company from its subsidiary were tax exempt, provided that such company was in turn not a subsidiary of another company, thus restricting the dividend benefit to two tier structures only. The budget now makes the dividend benefit applicable to multi-tier structures, thus providing a big fillip to large corporate groups which require multiple entities. For the purpose of this provision a company is regarded as a subsidiary of another company only where the parent holds more than half in nominal value of the equity share capital of the subsidiary.
Onshore fund structures
Venture capital funds / private equity funds play a significant role in the growth and development of the industry and encourage entrepreneurship resulting in multi-fold benefits to the economy. While until the year 2007 the regime for taxation of such funds under the erstwhile Section 10(23FB) of the Act offered a ‘pass through’ treatment to SEBI registered VCFs and Venture Capital Companies (“VCCs”), the amendments brought under this provision through the Finance Act, 2007 by limiting the ‘pass-through’ benefits to only certain identified sectors (like nanotechnology, information technology relating to hardware and software development, bio-technology, infrastructure, etc.) has since created a minefield of tax litigations for such funds. In response to a long standing demand from the industry, the Budget has sought to include certain key proposals reinstating the ‘pass-through’ status relevant to how Indian venture capital funds should be taxed.
The Budget proposes to extend the tax ‘pass-through’ status to VCFs / VCCs for their income from investments in Venture Capital Undertakings (“VCU”) operating in all sectors, except the ones specified in the negative list by SEBI (viz. non-banking financial services other than non-banking financial companies registered with the Reserve Bank of India (“RBI”) as equipment leasing or hire purchase companies, gold financing, etc.). Following such proposal, the income of VCFs / VCCs, from VCUs will be taxed directly in the hands of their investors. This is a welcome proposal, since the pass-through status granted to the SEBI registered VCFs put India at par with other countries, where the tax pass-through is automatically available in the form of choice of various entities or elections available such as LPs, etc.
Reflecting the true ‘pass-through’ position, not only the character of the income in the hands of the investor would be retained as that in the hands of a VCF / VCC, in a related proposal under the Budget it has been proposed that income shall be taxable in the hands of the investors the moment it accrues, arises or is received by the VCFs / VCCs. Currently, the income for the investors in the VCFs / VCCs was only taxable when actually received by them upon distribution irrespective of when such income having accrued or received by the VCF / VCC from the underlying VCUs.
However, considering that LLPs, may be eligible to register themselves with SEBI as VCF, the current proposal does not seem to cover them under the ambit of the tax ‘pass-through’ status. It would have been more prudent to include LLPs within the definition of a VCF or a VCC.
Offshore fund structures
While no specific provisions have been made in respect of offshore funds or foreign venture capital investors (“FVCI”), the Budget proposal to introduce GAAR could potentially spell trouble for offshore fund structures. GAAR provisions could bring into scrutiny any arrangement, unless it can be clearly demonstrated that availing tax benefits was not the main objective of the arrangement. More importantly, GAAR as proposed would have treaty override, which could put under question the treaty eligibility for any fund structure lacking commercial substance when they derive income from their investments in India. Further, through expansion of the definition of ‘capital asset’ and ‘transfer’ and the amendments to Section 9 of the Act to cover indirect transfers, investments structured through special purpose vehicles (“SPV”) for various commercial and regulatory reasons (e.g. real estate investments) could face potential risk of being taxed at the time of exit overseas.
To sum up, the proposals under the Budget for the VC industry would be welcome by the domestic fund as they would bring in much desired certainty and clarity on the taxability of the fund and its investors which should encourage increased activity in this space. In the past, the tax clarity and certainty has been a significant contributor to the growth and development of this asset class domestically. However, with the new Alternate Investment Fund (“AIF”) regime set to replace the existing SEBI (Venture Capital Regulations), 1996 widening the asset classes substantially, it needs to be seen as to what extent these provisions would cover within its ambit all these asset classes. If the proposals rely on the spirit of pass-through for any pooling structure, then it should also cover all AIFs irrespective of their strategy, but if the idea is only to limit these benefits to certain priority sectors like a venture capital fund, then the ambiguity for other classes of AIF shall remain. From an offshore fund perspective, it would be interesting to see whether the removal of sectoral restriction would be reciprocated by RBI’s vis-à-vis SEBI registered foreign venture capital investors (FVCIs). Following on from the 2007 restrictions on domestic VCFs, the RBI has been prescribing similar sectoral restrictions on FVCIs. Thus, there may be a case for a rethink at RBI level to remove such limitations on FVCI to bring them on par with VCFs. Also, structurally the tax certainty for domestic VCFs may encourage Indian GPs/fund managers to revert to the earlier tried and tested ‘unified structure’ (i.e. pooling of offshore fund into a domestic VCF) for their offshore funds resulting in relatively simplified the structure.
Advanced Pricing Agreements (‘APA’):
In a welcome move aimed at limiting the ever increasing transfer pricing disputes and to ensure greater certainty with respect to the Arm’s Length Price (‘ALP’) or alternately the methodology to be adopted to arrive at such ALP, the Budget proposes to introduce an APA regime.
The APA would be valid for a period of maximum of 5 years and the APA would be binding only on the taxpayer and the concerned Commissioner and his subordinates. If however there is a change in law or a fact post the execution of the APA, the APA shall cease to be valid from the date of such change. Further, the CBDT is empowered to declare any APA as invalid (void ab initio) if it finds that the APA has been obtained by fraud or misrepresentation of facts.
Domestic Transfer Pricing:
If the domestic transactions between two related persons or two units of the same entity exceed INR 50 million (USD 1 million), then in order to determine the correctness of (i) the income from domestic related party transactions and (ii) the domestic related party expenditure of the parties, the transfer pricing regulations (including procedural and penal provisions) would be extended to such domestic transactions as well.
While the rationale for the move is understandable, it shall no doubt increase the compliance burden of many a corporate tax payer. One significant issue that will remain is that while APA regime has been introduced with respect to international transactions, the same benefit has not been extended in cases of domestic transactions.
The Indian Government has been taking steps to address concerns with money laundering and non-disclosure of offshore assets by entering into exchange of information agreements with a number of offshore tax jurisdictions. This year, the emphasis on transparency and information collection continues via amendments to the Act.
In order to ensure that Indian residents report their worldwide assets, the Budget has proposed an amendment making it mandatory for all Indian residents to disclose all their overseas assets, whether in companies, partnerships or otherwise. This includes financial interests or even a signing authority in any offshore account. The return has to be filed regardless of the Indian resident having taxable income in the relevant financial year. The change proposed is akin to the tax practices prevalent in the U.S. which requires such reporting obligations, to enforce collection of taxes on worldwide income and for levy of estate duty.
In line with reporting requirements, the Budget also proposes changes with respect to the ability of tax authorities to reopen assessments for past years, both under the income tax and wealth tax regimes. The time limit for issue of notice for reopening an assessment has been increased from 6 to 16 years, if the income in relation to any offshore asset (including financial interest in any entity) is chargeable to tax and has escaped assessment. This increase in time limit can result in significant amount of distress for taxpayers since there will be an additional compliance burden for maintenance of records and issues relating to information gathering may arise.
While the practice of information reporting is indeed something that should be welcomed, one hopes that this move towards transparency coupled with the extended limitation period does not lead to an abuse of the process by the tax authorities.
As the service tax law exists today, taxable services have been defined and only those who fall within the ambit of these services are subject to service tax. The Budget proposes to adopt a diametrically opposite approach for levy of service tax in the country. With the intention of gradually transitioning towards the Goods and Service Tax regime, the Budget has proposed that the Service Tax law will henceforth follow the ‘Negative List approach’. Under this approach, all services, except those specified in the negative list and those specifically exempted, would be chargeable to service tax.
‘Service’ has been widely defined as “any activity carried out by a person for another for consideration …”, thereby bringing any “activity” whatsoever, regardless of whether it is a service, under the service tax net. To add to the uncertainty, the proposed new law does not differentiate between a service and a sale of goods, and hence a situation can arise where a taxpayer would be charged service tax and value added tax / sales tax in respect of the same ‘activity’.
Although, as pointed out by the Finance Minister, the new provisions will result in a substantial reduction in the ‘number of pages’ of the law, the sudden and significant widening of the tax base will lead to an increase in defaults in payment of tax and consequent litigation. A large number of service providers that were hitherto not covered by the tax net will now find themselves struggling to cough up the requisite taxes and the end result will be an increase in the cost of services.
Other important changes to service tax regime introduced by the Budget are:
a. Increase in the rate of service tax from 10% to 12%
b. The proposed introduction of a Revision Application Authority and Settlement Commission for dispute resolution in Service Tax matters.
c. Rationalization of the rules pertaining to point of taxation and restoration of CENVAT credits in a number of areas.
The ECB Policy contains a number of restrictions on the end-use of the borrowed funds, including use as working capital, repayment of rupee loans etc. However, recognizing the need for greater flexibility for utilization of ECBs, the Budget proposes to relax the end-use restrictions for ECBs in certain cases, including (a) part finance rupee debt of existing power projects; (b) capital expenditure on the maintenance and operations of toll systems for roads and highways, if they are part of original project (c) working capital requirement of airline industry for a period of one year, subject to a total ceiling of US $ 1 billion and (d) for low cost housing projects and setting up of a credit guarantee trust fund etc.
Further, in a bid to incentivize increased foreign lending in the power, airlines, roads and bridges, ports and shipyards, affordable housing, fertilizer and dams sectors, the Budget contains a proposal to reduce the withholding tax rate on interest payments on ECBs from 20% to 5% for a period of 3 years.
1 This may be subject to approval from the Central Government
2 Please click here to access our previous hotlines on the Vodafone case. (http://www.nishithdesai.com/New_Hotline/Tax/Tax%20Hotline_Jan2312.htm)
3 Krishnamurthi and Co. etc. v. State of Madras, AIR 1972 SC 2455.
4 The legislature has, over the last few years, taken to addressing disagreement with Supreme Court rulings by retrospectively amending the Act. Previously, in 2008, the income tax department had retrospectively amended Section 201 from 2002, dealing with an ‘assessee in default’ only to justify the notices issued to Vodafone.
5 National Agricultural Coop. Marketing Federation of India Ltd. v. Union of India, (2003) 181 CTR (SC) 1.
6 Subject to exceptions that are set out under the Act
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